'LIC's proposed investment will come out of what is technically called the 'policyholders funds'.'
'As the name implies, these monies belong to policyholders; that is, you, me and 25 crore others who have taken a total of 30 crore policies from LIC.'
'It is not the government's or LIC's money to play poker with,' says S Muralidharan, former managing director, BNP Paribas.
Illustration: Dominic Xavier/Rediff.com
A Moral Hazard is the lack of incentive to guard against risk where one is protected from its consequences. But what is an Immoral Hazard? Read on to find out.
Just when you thought the flow of bad news is easing, there is the grandmother of all bad news: LIC will buy a further 30% of IDBI Bank.
Why is this bad news?
There are at least three ways in which this is bad news; not just bad news, but a colossal 'moral hazard', as they say in insurance parlance.
There is some vagueness in the exact amount LIC will invest in IDBI. It is reported to already own 11%. The present shareholding is 81% by 'promoters', 11.76% by 'financial institutions', and retail and others own the rest.
IDBI started life in 1964 as a subsidiary of the RBI and in 1976 came under the direct control of the government, the better to serve the government's 'industrial development goals'.
A succession of the first family's pet poodles warmed the chairman's chair. In the best of times it was considered a 'soft' touch by businessmen desirous of starting a new venture (the other 'development' bank, ICICI, was still 'private' and reportedly had much higher standards for appraising credit).
The fact that IDBI was designated the 'lead Institution' for long term credit meant they had to take the lion's share (fool's share, it would later turn out) of the financing risk.
Although 'LIC' has become synonymous with 'life insurance', the public knows very little about LIC as a business enterprise: How it does business and what the results are.
LIC was the result of nationalisation and subsequent amalgamation of numerous life insurance companies in 1956. This nationalisation was sought to be justified by 'policyholder interest'.
Yes, there were some dubious practices by some of the privately-owned insurers in existence then.
Regulations in existence could have curbed all of those malpractices. New regulations could have been made if the old ones were inadequate.
Our governments haven't exactly been shy of making regulations for the flimsiest of reasons. Instead of tweaking regulations as needed, the government wheeled out the steamroller of nationalisation in order to crush the peanut of mismanagement.
As in bank nationalisation, the stated objective was a smokescreen to hide the government's real intent which was to gain control over the enormous funds that insurers generate and thus enjoy unparalleled access to and control over the financial markets.
Coming within 10 years of a newly-independent nation beset with various problems like extreme poverty, moribund economy, etc etc, the event went largely unnoticed by the general public.
The minuscule middle class which bought insurance perhaps felt relieved that they were free from the financial shenanigans of Lalaji-owned insurance companies.
No one gave it a second glance after the initial sigh of relief.
Let us come to the present day. In 2017, LIC reported a premium income of Rs 300,000 crores. Its investment income alone was Rs 164,000 crores.
It serviced 25 crore (250 million) policy-holders and 30 crore (300 million) policies.
It employs lakhs of agents for whom selling insurance policies is the sole source of income. If you count part-timers, the number will be in tens of lakhs.
LIC will probably beat the Railways as the largest employer!
Its policyholder's funds stood at Rs 23.3 lakh crores, a truly staggering sum.
Its investments, such as the proposed one in IDBI, come out of these funds.
Some reports suggest that LIC move will reduce government's holding to below 51% in IDBI, effectively 'divesting' it of government 'ownership'.
Why is this relevant to the issue at hand, which is LIC bailing out IDBI since both are government owned/controlled?
Left pocket or right pocket, what's the difference?
As it happens, its relevance is significant and raises some fundamental questions on the nature of government ownership of financial institutions, insurance and regulation.
It is my contention that the government ownership and control of LIC, IDBI and its control of banking and insurance regulators is highly questionable as to its intent, economic desirability, legality and political/public morality.
LIC's proposed investment will come out of what is technically called the 'policyholders funds'.
As the name implies, these monies belong to policyholders; that is, you, me and 25 crore others who have taken a total of 30 crore policies from LIC.
It is not the government's or LIC's money to play poker with, even if it is a sure shot.
IDBI is far from a sure bet.
The investment does not come out of what is called 'shareholders funds', or funds that belong to the 'owners' of the company, in this case the government.
LIC's 254 page annual report for 2017 shows in excruciating details how they have been toeing the government line, but not how much 'owners' money is invested in it.
A private enterprise can never hope to get away with this level of disclosure.
OK, I hear you say, Left-Pocket to Right-Pocket, so how does it matter?
Also, the investment will amount to Rs 7,000 crores to Rs 8,000 crores, small potatoes to LIC which collected annual premium of Rs 3 lakh crores in 2016-2017 and likely a similar amount in 2017-2018.
It is about 2% of its new premium and 0.3% of its total policyholder funds.
The quantum of investment and its materiality is the proverbial red herring; what is relevant is the government's cavalier attitude to governance, its penchant for applying band aid where surgery is required and utter disregard for the need to contain systemic risks.
The curious thing is, when LIC invests in IDBI, the purchase price does not go to IDBI, it goes to the government.
How then will IDBI's hole get plugged?
Reports peg the stressed assets of IDBI between 28% and 36%. They also suggest that qualitatively these are not merely 'stressed' but 'significantly impaired'.
Having received Rs 7,000 crores to Rs 8,000 crores from LIC, will the government put this money straight back in IDBI?
If so, as what?
How exactly will the bailing out of IDBI be accomplished?
LIC taking a major stake is not the end of the problem, not even the beginning of the end; it is just the beginning of a new headache.
How will LIC bring IDBI back to health?
It has the money, even if you have to overlook the small matter of how exactly it can infuse it into IDBI.
But does it have the managerial capability to run a bank long-blighted by cronyism, poor credit skills, given to pleasing the masters in North Block, and managing up rather than down.
LIC's own record of lending is none too good.
What exactly is the government hoping to achieve by making LIC do this?
Firstly they are trying to meet their divestment targets.
With Air India's divestment having soundly failed (are you surprised?), this deal can go towards meeting promises made in the Budget.
Not entirely, but every bit helps.
Clearly the deal is a financial fudge in order to meet political promises. It is also do-able without any help from Parliament.
Since IDBI does not come within the ambit of the Banking Companies Acquisition Act, the government does not have to go to gridlocked Parliament to get its approval.
Secondly, by reducing its stake in IDBI to below 51% the government can wash its hands of any future demands for capital.
There will be future need for heavy capital infusion, make no mistake about it.
For the government to wash its hand off, it has to reduce its present stake below 51%, which is where that magical number of 30% acquisition by LIC comes from.
Clearly this is an exercise at washing its hands of IDBI, without shuttering it down despite knowing it is a basket case.
What does LIC get out of it?
Simply and bluntly put, a bottomless pit into which it will have to pour money. Lots of it.
It is known that LIC has been harbouring dreams of becoming a financial supermarket. Without a bank those ambitions remain paper dreams.
This acquisition can get it going in that direction.
LIC already owns a mutual fund, housing finance company, credit cards company (presently limited to the LIC ecosystem of staff and agents), a pensions company, an assisted living company (under its housing finance Co) etc.
The missing element is a bank.
Very soon LIC will realise that owning and managing a bank is different from investing in one.
Should that thought bother LIC? It should. But does it bother them? I think not.
Why? Because of the mother of all moral hazards built into the working of LIC: Government Guarantee.
When LIC was created by the acquisition of disparate insurers in 1956, the ostensible reason was to protect the policyholder interests from the misdeeds of the previous owners.
So the government guaranteed every policyholder, present and future, of LIC. Not the best way to have taken care of the then problem, but acceptable in a socialist dispensation.
Then, as LIC was required to direct money into unviable and politically motivated investments and welfare schemes of all sorts, the guarantee continued in order that LIC could raise more money for more such schemes by selling more policies.
As capital markets became bigger and more systemically important, governments discovered that LIC's ability to move the market could be a powerful economic, political, and signalling tool.
Successive governments have used it. After the news of LIC's fresh investment in IDBI leaked out, the latter's stock is reported to have jumped 12%. Not bad for an all-but-bankrupt bank.
What we are witnessing here is a deal giving rise to two exotic types of risks which the public know nothing about and even the experts have only hazy idea of.
One is the contagion risk of a systemic problem in the banking sector (involving IDBI) infecting LIC and through it, the insurance and capital markets.
Sooner or later, the band-aid approach to fixing PSU banks will result in a banking crisis and when that happens, the weakest will be hardest hit.
Letting a bank fail might act as a safety valve, relieving the stresses in the system, albeit at some loss to its counter-party banks and depositors.
Depositor-protection laws can kick in to protect the small depositors or the government can step in at a reasonable cost as a one-time measure for the same purpose.
Importantly, the ability to protect the whole from the failure of a part is key to the survival of the financial system as a whole.
Think of it as the bank of circuit breakers at home: They do not guarantee against failure of any part but by confining failure to smaller sections they do protect the rest of the home.
In making all banks systemically big and important, this ability is lost.
An insurer owning a troubled bank is not only like not having circuit breakers in your home, but connecting the neighbourhood factories to your home without any circuit breakers.
This is contagion.
In the biological world we have seen how deadly it can be when viruses jump across species.
India survived the 2008 financial crisis relatively unaffected only because our capital controls isolated us from a contagion.
The second of the two risks is more insidious: It is the moral hazard created by the government's long-standing guarantee to LIC.
Long after the purpose and justification for such guarantee had passed, it was kept alive.
The government guaranteed all its policies, and LIC was happy to oblige by putting policyholders' money wherever the government wanted it, regardless of risk.
Effectively the government had totally and completely twisted and vitiated the insurance market.
Once again commercial decisions were reduced to toeing the government line.
While this was bad in itself when LIC was the only game in town, the government guarantee remained in place even after the constitution of the insurance regulator, IRDA, and issuance of licences to new insurance companies.
The whale continued to get government backing whereas the minnows did not.
This moral hazard is a Damocles' sword hanging over the Indian insurance industry as LIC continues to maintain a dominant market share of over 70%.
What is even more galling is that LIC barely even pretends to pay lip service to the regulator whilst genuflecting to greater gods in the North Block.
It could not have done this without the tacit support and encouragement of the government.
Just imagine, 70% of the life insurance industry is beyond the real reach of the insurance regulator.
It is an immoral hazard if you ask me.
If you thought that is the mother of moral hazards, here comes the grandmother: When the rumours of LIC's investment in IDBI started, the regulator IRDA was rightly concerned and appeared to oppose it.
IRDA's position was based on the prudent investment limits it had put in place for all insurers. The LIC-IDBI deal will violate those norms.
The mandarins and netas of North Block saw red and the IRDA buckled; after all they appoint its chairman.
The RBI, the banking regulator, remained silent, no doubt chastened by earlier encounters with North Block.
When a government asks an insurer it guarantees to take over a dying bank it owns over the objections of the regulator it appoints who then buckles, it is called immoral hazard.
S Muralidharan retired as managing director, BNP Paribas, after serving the bank for 20 years.
